Indonesia - The Economy Role of Government

Trade and Industrial Reform

Indonesia's industrialization during the 1970s and early 1980s was accompanied by a growing web of trade restrictions and government regulations that made private businesses the hostage of government approval or protection. The dictates of the market had little bearing on profitability, and even the most inefficient firms could prosper with the right government connections. As a consequence, almost all of Indonesia's industrial production was sold on domestic markets, leaving exports dominated by oil and agricultural products.

Major trade policy reforms, introduced in the mid-1980s, went a long way toward disentangling the government from the marketplace. These reforms proved very successful in promoting the growth of new export industries. Still, the large conglomerates that had emerged under heavy regulations also had the resources to benefit most in the more competitive environment. By the early 1990s, the government still confronted widespread popular concern over the distribution of gains from economic development.

The industrial and trade policy favored by government through the early 1980s was characterized by development economists as import-substitution industrialization. As illustrated by the steel industry example discussed above, the typical pattern was to encourage domestic producers to invest in a priority sector, selected by the Department of Industry, that could substitute domestic production for products previously imported. The enticement offered to the domestic investor often included sole license to import the product and restrictions on other potential domestic producers. The Department of Trade issued import licenses, and BKPM, which had jurisdiction over investment by all foreign firms and most large domestic firms, provided the constraints to potential domestic competitors. The overall direction of industrialization was framed in five-year development plans, but political influence often led to a more capricious pattern of benefits. In addition to almost 1,500 nontariff restrictions, such as import license requirements, tariffs ranging up to 200 percent of the value of an import were in place on those imports not affected by licensing.

The inefficiencies that plagued this strategy were documented by Department of Finance economists who were preparing for a major tax reform implemented in 1985. Case studies of firms in import substitute sectors showed they generated 25 percent of employment opportunities that investment in potential exports would have supplied, and that shifting investment from an import substitute to an export product would generate four times the foreign-exchange earnings. Indonesia thus was left out of the substantial regional growth in manufactured exports during the early 1980s. In Thailand and Malaysia, manufactured exports accounted for 25 and 18 percent of exports, respectively, by 1980, whereas manufactured exports generated only about 2 percent of total Indonesian exports that year.

The complexity of trade regulations provided a rich opportunity for corruption within the Customs Bureau, which administered policies and assessed the value of imports to determine the appropriate tariffs. In April 1985, the Customs Bureau was released from its responsibilities, and a Swiss firm, Société Générale de Surveillance, was contracted to process all imports valued over US$5,000. Société Générale de Surveillance determined the value of imports into Indonesia at their port of origin and shipped the products in sealed crates to the Indonesian destination. Importers within Indonesia reported that their import costs fell by over 20 percent within months of the reform.

The first measure to directly curtail high trade barriers came in the form of an export certification program designed to offset the high costs for exporters who purchased imported inputs. This was abandoned, however, when the United States threatened to curtail textile imports from Indonesia because of the alleged subsidy from the certification scheme. In response, Indonesia agreed to sign the General Agreement on Tariffs and Trade (GATT) Export Subsidy Accord in 1985. This provided a further impetus for more substantial trade reform since the agreement prohibited government compensation for export costs created by nontariff barriers to imported inputs.

In May 1986, the first in a series of more substantial trade reforms was announced. The reform package provided duty refunds for tariffs paid on the imports of domestic producers who exported a substantial share of their products. To overcome the problem of nontariff barriers, such as licensing restrictions on imports, exporters were granted the right to import their own inputs, even if another firm previously had exclusive privilege to import the product. Restrictions on foreign investment were reduced, particularly to stimulate production for export.

Although these reforms improved profits of exporting firms, they did not help to encourage exports from firms that preferred to supply the protected domestic market. In November 1988, a major trade reform began to dismantle the extensive nontariff barriers and to lower and simplify tariffs rates. By eliminating the influential plastics and steel import monopolies, government indicated the seriousness of the new policy direction. The 1988 reforms brought the share of domestic manufacturing protected by nontariff barriers to 35 percent from 50 percent in 1986.

Deregulation continued in a series of reform packages affecting both direct trade barriers and government regulations that indirectly influenced the "high-cost" business climate. By 1990 nontariff barriers affected only 660 import items, compared with 1,500 items two years earlier. Tariffs, still charged on almost 2,500 different imported items, had a maximum rate of 40 percent. BKPM adopted a new policy in 1989 to list only those economic sectors in which investment was restricted; the negative list replaced a complex Priority Scale List that had controlled investment in virtually all sectors. In 1991 the contract with Société Générale de Surveillance was renewed under new provisions mandating that the Customs Bureau be trained to eventually replace the foreign firm.

Most of the substantial reforms that began in the mid-1980s and continued through the early 1990s reflected a new orientation to market-led economic development. In some cases, however, important new policies reflected the longstanding government concern that the private marketplace could not be trusted to ensure politically desirable outcomes. This was particularly true of policies concerning the processing of Indonesia's valuable natural resources and the sensitive area of pribumi business development.

Indonesia was the world's leading exporter of tropical logs in 1979, accounting for 41 percent of the world market. Concerns about environmental degradation and the lack of domestic log processing capacity led to restrictions on log exports beginning in 1980, culminating in a complete ban on log exports in 1985. The intent was primarily to foster the nascent plywood and sawmill industry, which could in turn export its output and expand employment and industry within the country. By 1988 Indonesia supplied almost 30 percent of world exports of plywood. The success of this policy led to other similar initiatives, including a ban on raw rattan exports in 1988 to foster the domestic rattan furniture industry and a substantial export tax on sawn timber in 1990 to promote the domestic wood furniture industry.

Many benefits that fostered the growth of large conglomerates were reduced or eliminated, but the conglomerates adapted quickly to the new environment. For example, the Bimantara Citra Group, operated by Suharto's son Bambang, lost its plastics import license held through Panca Holdings in 1988 but gained new interests in sectors that had previously been closed to private investment. The group became the first Indonesian company permitted to establish a privately owned television station--Rajawali Citra Televisi Indonesia (RCTI)--and, in the early 1990s, was poised to invest in petrochemical plants, long a government stronghold. Another son, Tommy Suharto, had a major holding in Sempati Air Services, the first private Indonesian airline permitted to offer international jet service in competition with the government airline monopoly, Garuda Indonesia. An extensive review of Suharto family holdings published in the Far Eastern Economic Review in April 1992 noted that public resentment of family business gains was growing, although government officials and businessmen refused to voice their concern openly.

The government took some measures to curtail the continued dominance of large conglomerates. In 1990 Suharto himself publicly called for large business conglomerates to sell up to 25 percent of their corporate shares to employee-owned cooperatives on credit supplied by the conglomerates themselves, to be repaid with future stock dividends. The request was not legally mandated, but the attendant publicity that clearly identified the major Chinese minority firms involved was viewed as pressure to comply. Within a year, 105 companies had sold much smaller shares of stocks, diluted by special nonvoting provisions, to the cooperatives. A further initiative in 1991 called for large firms to become the "foster fathers" of smaller pribumi businesses, which would serve as their suppliers, retailers, and subcontractors.

Large, state-owned enterprises faced greater competition, but privatization of these operations did not seem likely in the early 1990s. During the late 1980s, however, several measures were undertaken to prepare for possible eventual privatization, including a thorough independent assessment of the profitability of each enterprise and a review of management compensation in relation to performance criteria. In 1988 the Department of Finance issued a new regulation outlining measures that could be taken to improve the performance of state-owned enterprises. The measures included management contracts with the private sector, issuing private ownership shares on capital markets or direct sale to private owners, and liquidation.

Another government policy initiated in 1989 suggested that at least some state-owned industries would be protected from possible privatization. A Council for the Development of Strategic Industries was established, headed by Minister of State for Research and Technology Habibie. The council gained control of ten major state enterprises, including several munitions plants, the state aircraft firm Archipelago Aircraft Industry (IPTN), and Krakatau Steel. Under Habibie the industries' long-term development would be coordinated with continued government funding. This policy, viewed as a concession to the economic nationalists in the midst of government cutbacks, assured a major role for state-owned industries in Indonesia's most technologically sophisticated sectors.

The Politics of Economic Reform

Two main forces of influence within the New Order government battled to shape economic policy: the technocrats--who favored market reforms and a limited role for the government in the economy--and economic nationalists--who argued that trade protection and direct government investment and regulation were necessary to contain foreign influence while mobilizing sufficient resources to modernize the economy. The technocrats were led by the original members of the "Berkeley Mafia," who had gained cabinet posts in the late 1960s. Among the most influential technocrats were Ali Wardhana, initially the minister of finance in 1967 and coordinating minister of economics, finance, and industry from 1983 to 1988, and Widjojo Nitisastro, who headed the National Development Planning Board (Bappenas--for this and other acronyms, see table A), from 1967 to 1983. Although retired by 1988, both men remained influential behind-the-scenes advisers in the early 1990s. Under the tutelage of Professor Sumitro Djojohadikusumo, a prominent intellectual and cabinet member in the 1950s who founded the University of Indonesia Faculty of Economics during the 1960s, these Western-trained economists were the voice of economic liberalism. The economic nationalists included prominent officials in the Department of Industry, headed by Hartarto; offices under the minister of state for research and technology, Bacharuddin J. Habibie; and the Investment Coordinating Board (BKPM). The balance of power between the economic technocrats and the economic nationalists was mediated by Suharto, who skillfully channeled the energies of both groups into separate arenas.

After the New Order successfully countered the rampant inflation and financial collapse of the Sukarno era, the technocrats gained credibility and influence in the domain of financial and fiscal policy. As oil revenues grew in the 1970s, those government agencies responsible for trade and industrial policy sought to extend Indonesia's domestic industrial base by investing in basic industries, such as steel and concrete, and by erecting trade barriers to protect domestic producers from excessive foreign competition. Government regulations proliferated, and oil taxes fueled investment in development projects and state enterprises.

The private sector became dominated by large conglomerate corporations, often Chinese minority-owned, which had sufficient wealth and know-how to assist the government in large-scale modernization projects. Australian economist Richard Robison estimated that Chinese Indonesian capital accounted for 75 percent of private-sector investment in the 1970s. The two most prominent conglomerates, the Astra Group and the Liem Group, had substantial holdings in dozens of private firms ranging from automobile assembly to banking. The growth of these conglomerates usually hinged on close ties to government. In exchange for monopoly privileges on production and imports of key industrial products, conglomerates would undertake large-scale investment projects to help implement government industrialization goals. Political patronage became a vital component of business success in the early 1980s as government restrictions were extended to curtail imports when oil revenues began to decline.

By the mid-1980s, about 1,500 items representing 35 percent of the value of imports were imported either by licensed importers or controlled through a quota system. Such nontariff barriers affected virtually all manufactured imports, but were particularly extensive for textiles, paper and paper products, and chemical products. As a result of restrictions on imports, firms in these sectors were effectively protected from foreign competition or able to sell their products at a higher cost. Firms that obtained import licenses were also highly profitable, but costs were borne by the entire economy because imports were often key inputs for many manufacturers. Popular resentment grew as the gains from these restrictions enriched a privileged minority. To the long-standing public sensitivity toward the prominence of the Chinese minority was added dismay that members of Suharto's family were profiting from access to import monopolies.

Suharto's six children were the most visible beneficiaries of close government connections. Each child was connected with one or more conglomerates with diverse interests, and like their Chinese minority counterparts, they based their business success at least partly on lucrative government contracts. For example, son Bambang Trihatmodjo's Bimantara Citra Group, reportedly the largest family conglomerate by the 1990s and Indonesia's fifth largest company in 1992, got its start in the early 1980s selling allocations of overseas oil to the National Oil and Natural Gas Mining Company (Pertamina)--the government oil monopoly and the nation's largest company. Lower value middle East oil was thus used for domestic refining and consumption while higher-grade Indonesian oil was used for export, primarily to Japan.

Two vital industries symbolized the intricate relationship between government and business: steel and plastics. In the first case, the founder of the Liem Group, Liem Sioe Liong, agreed in 1984 to invest US$800 million to expand a government enterprise, Krakatau Steel, in Cilegon, Jawa Barat Province, to add production of cold-rolled sheet steel. In return, a company owned partly by Liem received a monopoly for the imports of cold-rolled steel. Once domestic production was underway, Liem's imports were restricted to assure demand for the Krakatau product. The World Bank estimated that the scheme added 25 to 45 percent to the cost of steel sheets in Indonesia, thereby raising costs of a wide range of industrial products that used this material. In the second case, the importation of plastic raw materials was monopolized through government license by Panca Holding Limited, on whose board of directors sat Suharto's son, Bambang, and his brother, Sigit Harjojudanto. As a result, in 1986 the company earned US$30 million on US$320 million worth of plastics imports, adding 15 to 20 percent to the price of these materials for Indonesian users.

When oil prices plummeted in 1986, the growing dissatisfaction with the direction of trade and industrial policy became more vocal among small private businesses excluded from the benefits. A number of smaller businesses organized the Chamber of Commerce and Industry in Indonesia (Kadin). These businesses became open critics of the "high-cost" economy of monopoly privilege, and in 1987 Kadin became the officially sanctioned channel of communication between business and government. Other influential groups began to pressure the government for trade reforms, including international lenders on whom Indonesia relied to assist the government with balance of payments difficulties resulting from the decline in oil revenues.

Several major reforms were underway before the 1986 oil crisis, but without direct affect on trade restrictions, which although valued by influential beneficiaries, had become costly to many businesses. Major trade deregulation began in 1986, but left the largest import monopolies untouched until 1988, a gradual approach to reform that influential technocrat Ali Wardhana attributed to the limitations of the government bureaucracy. He hinted at a broader political motive, however, in acknowledging that piecemeal reforms had the advantage of progressively winning a new constituency for further reform. The financial sector was the first sector to be reformed in the 1980s, as it was in the mid-1960s, when the New Order government faced the excesses of the previous regime.

Financial Reform

The president's technocratic advisers on financial policy, who had unsuccessfully resisted growing government regulations during the 1970s, spearheaded the return to market-led development in the 1980s. The financial sector is often the most heavily regulated sector in developing countries; by controlling the activities of relatively few financial institutions, governments can determine the direction and cost of investment in all sectors of the economy. From the 1950s to the early 1980s, the Indonesian government frequently resorted to controls on bank lending and special credit programs at subsidized interest rates to promote favored groups. Toward the end of this period, the large state banks that administered government programs were often criticized as corrupt and inefficient. Sweeping reforms began in 1983 to transform Indonesia's government-controlled financial sector into a competitive source of credit at market-determined interest rates, with a much greater role for private banks and a growing stock exchange. By the early 1990s, critics were more likely to complain that deregulation had gone too far, introducing excessive risk taking among highly competitive private banks.

Like many developing countries, the Indonesian financial sector historically was dominated by commercial banks rather than by bond and equity markets, which require a mature system of accounting and financial information. Several established Dutch banks were nationalized during the 1950s, including de Javasche Bank, or Bank of Java, which became the central bank, Bank Indonesia, in 1953. Under Sukarno's Guided Economy, the five state banks were merged into a single conglomerate, and private banking virtually ceased. One of the first acts of the New Order was to revive the legal foundation for commercial banking, restoring separate state banks and permitting the reestablishment of private commercial banks and a limited number of foreign banks.

During the 1970s, state banks benefited from supportive government policies, such as the requirement that the growing state enterprise sector bank solely with state banks. State banks were viewed as agents of development rather than profitable enterprises, and most state bank lending was in fulfillment of governmentmandated and subsidized programs designed to promote various economic activities, including state enterprises and small-scale pribumi businesses. State bank lending was subsidized through Bank Indonesia, which extended "liquidity credits" at very low interest rates to finance various programs. By 1983 such liquidity credits represented over 50 percent of total state bank credit. Total state bank lending in turn represented about 75 percent of all commercial bank lending. The nonstate banks--which by 1983 numbered seventy domestic banks and eleven foreign or joint-venture banks--had been curtailed during the 1970s by licensing restrictions, even though they offered competitive interest rates on deposits and service superior to that offered by the large bureaucratic state banks. Bank Indonesia also imposed credit quotas on all banks to reduce inflationary pressures generated by the oil boom.

The first major economic reform of the 1980s permitted a greater degree of competition between state and private banks. In June 1983, credit quotas were lifted and state banks were permitted to offer market-determined interest rates on deposits. Many of the subsidized lending programs were phased out, although certain priority lending continued to receive subsidized refinancing from Bank Indonesia. Also, important restrictions remained, including the requirement that state enterprises bank at state banks and limitations on the number of private banks. By 1988 state banks still accounted for almost 70 percent of total bank credit, and liquidity credit still accounted for about 33 percent of total state bank credit.

In October 1988, further financial deregulation essentially eliminated the remaining restrictions on bank competition. Limitations on licenses for private and foreign joint-venture banks were lifted. By 1990 there were ninety-one private banks--an increase of twenty-eight in a single year--and twelve new foreign joint-venture banks, bringing the total foreign and joint-venture banks to twenty-three. State enterprises were permitted to hold up to 50 percent of their total deposits in private banks. Later, in January 1990, many of the remaining subsidized credit programs were eliminated.

The extensive bank deregulations promoted a rapid growth in rupiah-denominated bank deposits, reaching 35 percent per year when controlled for inflation in the two years following the October 1988 reforms. This rapid growth led to concerns that competition had become excessive; concern was heightened by the near failure of the nation's second largest private bank, Bank Duta. The bank announced in October 1990 that it had lost more than US$400 million, twice the amount of its shareholders' capital, in foreign exchange dealings. The bank was saved by an infusion of capital from its shareholders, which included several charitable foundations chaired by Suharto himself. The spectacular crash of Bank Summa in November 1992 was not protected by Bank Indonesia. Its owner, a highly respected wealthy businessman, was forced to liquidate other assets to cover depositors' losses.

Unrestricted transactions in foreign exchange by Indonesian residents had been a unique feature of the financial sector since the early 1970s. While many developing countries attempt to outlaw such so-called capital flight, the New Order continued to permit Indonesian residents to invest in foreign financial assets and to acquire the foreign exchange necessary for investments through Bank Indonesia without limit. Commercial banks in Indonesia, including state banks, were also permitted since the late 1960s to offer foreign currency--usually United States dollar--deposits, giving rise to the so-called Jakarta dollar market. By 1990 20 percent of total bank deposits were denominated in foreign currency. This freedom to invest in foreign exchange served the financial institutions well. During the 1970s, when banks' domestic credit activities were heavily restricted, most banks found it profitable to hold assets abroad, often well in excess of their foreign exchange deposits. When demand for domestic credit was high, banks resorted to international borrowing to finance expanding domestic loans. To control the domestic supply of credit by plugging the offshore leak, in March 1990, Bank Indonesia issued a new regulation that limited the net foreign position of a bank (the difference between foreign assets and liabilities) to 25 percent of the bank's capital.

Prior to bank reforms in October 1988, some private banks were essentially the financial arm of large business conglomerates and consequently did not make loans to businesses outside those connected with the bank's owners. The 1988 bank reforms limited loans to businesses owned by bank shareholders. When many of the government-subsidized credit programs targeted to small businesses were eliminated in January 1990, the government required banks to lend a 20 percent share of their loan portfolio to small businesses, defined as those businesses with assets, excluding land, worth less than Rp600 million (about US$300,000). This aspect of financial reform ran counter to the overall effort to improve bank efficiency, since the rule applied to all banks regardless of their expertise in small-scale lending. However, the policy reflected the government's persistent concern that the public might perceive the benefits of economic growth as limited to the wealthy few.

One of the most striking outcomes of financial reform was the revival of the Jakarta stock market in the late 1980s. Established in 1977, the stock market had become lifeless during the early 1980s because of extensive regulation of stock issues and price movements. In conjunction with substantial bank reforms, many restrictions on the Jakarta Stock Exchange were lifted in the mid1980s , broadening the range of firms that could issue equity and permitting stock prices to reflect market supply and demand. To tap the growing international interest in Asian investments, foreign ownership was permitted for up to 49 percent of an Indonesian firm's issued capital. The market's response to these reforms was dramatic. The number of firms listed on the exchange rose from 24 in 1988 to 125 in January 1991, and the market capitalization--the total market value of issued stocks--reached more than Rp12 billion. Although this amount of market capitalization was less than 15 percent of the volume of bank credit to private firms, the stock market promised to become an increasingly important source of finance.

Role of government

In the early years of nation building, from 1950 to 1957, a variety of moderate policies were pursued to support the pribumi through subsidized credit from the state-owned Bank Rakyat, or People's Bank, and through limiting certain markets to pribumi business. The nation's first five-year development plan (1956-60) proposed a realistic level of government investment in public infrastructure, but offered little regulation or overall guidance to the private sector. This plan was superseded by dramatic developments in the political and economic sphere, including the 1957 takeover of Dutch enterprises initiated by workers, which led ultimately to state control of this important segment of the economy. About 300 Dutch plantations and 300 firms in other areas such as mining, trade, finance, and utilities ultimately came under the control of the Indonesian government. Dutch management was replaced by Indonesian civil servants or military officers, most of whom had little managerial experience.

The de facto expansion of the state was sustained by a general policy shift to justify greater state intervention in the economy. Sukarno's Guided Economy was initiated in a new eight-year development plan begun in 1959, which entailed a twelvefold increase in government project expenditure from the previous plan, without clear sources of finance. By the mid-1960s, central bank credit to the government accounted for half of government expenditures. This deficit spending led in turn to mounting inflation, which peaked at 1,500 percent between June 1965 and June 1966. At the same time, foreign debt mounted, both from the West and increasingly from the Soviet Union. In spite of a highly visible public building campaign, the economy stagnated and by 1966 per capita production was below the 1958 level.

Following the downfall of Sukarno, the New Order regime under Suharto pursued, with financial assistance from the International Monetary Fund (IMF), a variety of emergency stabilization measures to put the economy back on course. During the 1960s, a team of economists from the Faculty of Economics at the University of Indonesia became influential presidential advisers. Because three of the five-member team had received doctorates from the University of California at Berkeley, the group was sometimes referred to as the "Berkeley Mafia." Chief among the Berkeley group's recommended reforms was a balanced budget, although foreign assistance and foreign borrowing were included as sources of revenue. Furthermore, in a break from the socialist tenor of Sukarno's Guided Economy, Suharto's New Order heralded a return to private market development.

The New Order remained committed to a stable economic environment encouraged by responsible fiscal and monetary policy, but concerns over foreign economic dominance, the limited national industrial base, and the need for pribumi economic development mandated increased government regulation during the 1970s. In spite of these increasing government controls, the economy continued to prosper throughout the 1970s, with GDP growing an average 8 percent annually.

By the early 1980s, a precipitous drop in growth pointed to limits in the industrialization strategy, and a new generation of reformers advocated a more limited role for the government. Entrenched beneficiaries of protected markets and enlarged bureaucracies resisted these reforms, but when the oil market collapsed in 1986, the balance was tipped in favor of the "freefight " advocates.